Dibrugarh University Financial Management Solved Question Papers
2013 (November)
Commerce (Speciality)
1.
Write true or false: 1x4=4 Marks
a)
Wealth maximization is a socialistic approach. True
b)
Cash management is an important task of finance
manager. True
c)
Capital expenditure involves non-flexible short
term commitment of funds. False
d)
Financial leverage is also known as Trading on
Equity. True
2.
Choose the appropriate answer from the given
alternatives: 1x4=4
Marks
(a) Financial
decisions involve with
(i)
Investment,
financing and dividend decisions
(ii) Investment,
financing and sales decisions
(iii) Financing,
dividend and cash decisions
(b) Factoring
is a method of raising
(i) Long term
finance
(ii) Medium
term finance
(iii) Short term finance
(c) Financing
leverage =
(i) Contribution/Earnings
before interest and tax
(ii)
Earnings
before interest and tax/Earnings before tax
(iii) Earning
after interest and tax/Earnings after tax
(d) Debenture
securities carry
(i) Voting
rights and dividend
(ii) Interest
and voting rights
(iii) Interest
and dividend
(iv) Interest only
3.
Write short notes on (any four)
a) Wealth maximization: Shareholders’ wealth maximization means maximizing the net present value
of a course of action to shareholders. Net Present Value (NPV) of a course of
action is the difference between the present value of its benefits and the
present value of its costs. A financial action that has a positive NPV creates
wealth for shareholders and therefore, is desirable. A financial action
resulting in negative NPV destroys shareholders’ wealth and is, therefore
undesirable. Between mutually exclusive projects, the one with the highest NPV
should be adopted. NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders
Wealth Maximization (SWM) considers timing and risk of expected benefits.
Benefits are measured in terms of cash flows. One should understand that in
investment and financing decisions, it is the flow of cash that is important,
not the accounting profits. SWM as an objective of financial management is
appropriate and operationally feasible criterion to choose among the
alternative financial actions.
Maximizing the shareholders’
economic welfare is equivalent to maximizing the utility of their consumption
over time. The wealth created by a company through its actions is reflected in
the market value of the company’s shares. Therefore, this principle implies
that the fundamental objective of a firm is to maximize the market value of its
shares. The market price, which represents the value of a company’s shares, reflects
shareholders’ perception about the quality of the company’s financial
decisions. Thus, the market price serves as the company’s performance
indicator.
In such a case, the financial
manager must know or at least assume the factors that influence the market
price of shares. Innumerable factors influence the price of a share and these
factors change frequently. Moreover, the factors vary across companies. Thus,
it is challenging for the manager to determine these factors.
b) Payback period
method: It is one of the simplest methods to calculate period within which
entire cost of project would be completely recovered. It is the period within
which total cash inflows from project would be equal to total cash outflow of
project. It is calculated by dividing initial investments in project by annual
cash inflows. Here, cash inflow means profit after tax but before depreciation.
Merits of
Payback period Method
a) This method of evaluating proposals for
capital budgeting is simple and easy to understand, it has an advantage of
making clear that it has no profit on any project until the payback period is
over i.e. until capital invested is recovered. This method is particularly
suitable in the case of industries where risk of technological services is very
high.
b) In case of routine projects also, use of
payback period method favours projects that generates cash inflows in earlier
years, thereby eliminating projects bringing cash inflows in later years that
generally are conceived to be risky as this tends to increase with futurity.
Limitations
of payback period
a) It stresses capital recovery rather than
profitability. It does not take into account returns from the project after its
payback period.
b) This method becomes an inadequate measure
of evaluating 2 projects where the cash inflows are uneven.
c) This method does not give any consideration
to time value of money, cash flows occurring at all points of time are simply
added.
d) Post-payback period profitability is
ignored totally.
c) Financial leverage: A Leverage
activity with financing activities is called financial leverage. Financial
leverage represents the relationship between the company’s earnings before
interest and taxes (EBIT) or operating profit and the earning available to
equity shareholders. Financial leverage is defined as “the ability of a firm to
use fixed financial charges to magnify the effects of changes in EBIT on the
earnings per share”. It involves the use of funds obtained at a fixed cost in
the hope of increasing the return to the shareholders. Financial leverage can
be calculated with the help of the following formula:
FL = OP/PBT
Where,
FL = Financial leverage
OP = Operating profit (EBIT)
PBT = Profit before tax.
Degree of Financial Leverage: Degree
of financial leverage may be defined as the percentage change in taxable profit
as a result of percentage change in earnings before interest and tax (EBIT).
This can be calculated by the following formula: DFL= Percentage change in
taxable Income / Percentage change in EBIT
d) Optimal payout ratio: The
dividend payout ratio measures the percentage of net income that is distributed
to shareholders in the form of dividends during the year. In other words, this
ratio shows the portion of profits the company decides to keep to fund operations
and the portion of profits that is given to its shareholders. Investors are
particularly interested in the dividend payout ratio because they want to know
if companies are paying out a reasonable portion of net income to investors.
The dividend payout formula is calculated by dividing total dividend by the net
income of the company i.e.
Dividend Payout Ratio = Total Dividend/Net
income
Optimal
Dividend Payout Ratio: Dividend payout ratio maximizes the firm’s
value. A payout ratio which maximizes the firm’s value is called optimal
dividend payout ratio. A firm achieves this dividend payout-ratio at that point
where it minimises the total cost of financing.
The minimization of sum of total cost of financing produces a unique
dividend payout ratio for the firm.
e) Management of cash
4.
(a) The finance manager is responsible for shaping
the fortunes of the enterprise and is involved in the most vital decision of
the allocation of capital. Explain.
Ans: Role and Functions
of Finance Manager
In the modern enterprise, a finance manager
occupies a key position, he being one of the dynamic member of corporate
managerial team. His role, is becoming more and more pervasive and significant
in solving complex managerial problems. Traditionally, the role of a finance
manager was confined to raising funds from a number of sources, but due to
recent developments in the socio-economic and political scenario throughout the
world, he is placed in a central position in the organisation. He is
responsible for shaping the fortunes of the enterprise and is involved in the
most vital decision of allocation of capital like mergers, acquisitions, etc. A
finance manager, as other members of the corporate team cannot be averse to the
fast developments, around him and has to take note of the changes in order to
take relevant steps in view of the dynamic changes in circumstances.
The nature of job of an accountant and finance
manager is different, an accountant's job is primarily to record the business
transactions, prepare financial statements showing results of the organisation
for a given period and its financial condition at a given point of time. He is
to record various happenings in monetary terms to ensure that assets,
liabilities, incomes and expenses are properly grouped, classified and
disclosed in the financial statements. Accountant is not concerned with
management of funds that is a specialised task and in modern times a complex
one. The finance manager or controller has a task entirely different from that of
an accountant, he is to manage funds. Some of the important decisions as
regards finance are as follows:
1. Estimating
the requirements of funds: A business requires funds for long term purposes
i.e. investment in fixed assets and so on. A careful estimate of such funds is
required to be made. An assessment has to be made regarding requirements
of working capital involving, estimation of amount of funds blocked in current
assets and that likely to be generated for short periods through current
liabilities. Forecasting the requirements of funds is done by use of techniques
of budgetary control and long range planning.
2. Decision
regarding capital structure: Once the requirement of funds is estimated, a
decision regarding various sources from where the funds would be raised is to
be taken. A proper mix of the various sources is to be worked out, each source
of funds involves different issues for consideration. The finance manager has
to carefully look into the existing capital structure and see how the various proposals
of raising funds will affect it. He is to maintain a proper balance between
long and short term funds.
3. Investment
decision: Funds procured from different sources have to be invested in
various kinds of assets. Long term funds are used in a project for fixed and
also current assets. The investment of funds in a project is to be made after
careful assessment of various projects through capital budgeting. A part of
long term funds is also to be kept for financing working capital requirements.
Asset management policies are to be laid down regarding various items of
current assets, inventory policy is to be determined by the production and
finance manager, while keeping in mind the requirement of production and future
price estimates of raw materials and availability of funds.
4. Dividend
decision: The finance manager is concerned with the decision to pay or
declare dividend. He is to assist the top management in deciding as to what
amount of dividend should be paid to the shareholders and what amount is retained
by the company, it involves a large number of considerations. The principal
function of a finance manager relates to decisions regarding procurement,
investment and dividends.
5. Maintain Proper Liquidity: Every
concern is required to maintain some liquidity for meeting day-to-day needs.
Cash is the best source for maintaining liquidity. It is required to purchase
raw materials, pay workers, meet other expenses, etc. A finance manager is
required to determine the need for liquid assets and then arrange liquid assets
in such a way that there is no scarcity of funds.
6. Management of Cash, Receivables and
Inventory: Finance manager is required to determine the quantum and manage
the various components of working capital such as cash, receivables and
inventories. On the one hand, he has to ensure sufficient availability of such
assets as and when required, and on the other there should be no surplus or
idle investment.
7. Disposal of Surplus: A finance manager
is also expected to make proper utilization of surplus funds. He has to make a
decision as to how much earnings are to be retained for future expansion and
growth and how much to be distributed among the shareholders.
8. Evaluating
financial performance: Management control systems are usually based on
financial analysis, e.g. ROI (return on investment) system of divisional
control. A finance manager has to constantly review the financial performance
of various units of the organisation. Analysis of the financial performance
helps the management for assessing how the funds are utilised in various
divisions and what can be done to improve it.
9. Financial
negotiations: Finance manager's major time is utilised in carrying out
negotiations with financial institutions, banks and public depositors. He has
to furnish a lot of information to these institutions and persons in order to
ensure that raising of funds is within the statutes. Negotiations for outside
financing often require specialised skills.
10. Helping in Valuation Decisions: A
number of mergers and consolidations take place in the present competitive
industrial world. A finance manager is supposed to assist management in making
valuation etc. For this purpose, he should understand various methods of
valuing shares and other assets so that correct values are arrived at.
Or
(b) What is financial
management? Discuss its significance in modern era. State the objectives of
financial management.
Ans: Financial management is management principles and
practices applied to finance. General management functions include planning,
execution and control. Financial decision making includes decisions as to size
of investment, sources of capital, extent of use of different sources of
capital and extent of retention of profit or dividend payout ratio. Financial
management, is therefore, planning, execution and control of investment of
money resources, raising of such resources and retention of profit/payment of dividend.
Howard and Upton define financial management as
"that administrative area or set of administrative functions in an
organisation which have to do with the management of the flow of cash so that
the organisation will have the means to carry out its objectives as
satisfactorily as possible and at the same time meets its obligations as they
become due.”
According to Guthamann and Dougall,” Business finance
can be broadly defined as the activity concerned with the planning, raising,
controlling and administering the funds used in the business.”
Bonneville and Dewey interpret that financing consists
in the raising, providing and managing all the money, capital or funds of any
kind to be used in connection with the business.
Osbon defines financial management as the
"process of acquiring and utilizing funds by a business”.
Considering all these views, financial management may
be defined as that part of management which is concerned mainly with raising
funds in the most economic and suitable manner, using these funds as profitably
as possible.
Significance of financial management in the present day
business world
The scope and significance of financial
management can be discussed from the following angles:
1)
Importance to Organizations
a) Business
organizations: Financial management is important to all types of business
organization i.e. Small size, medium size or a large size organization. As the
size grows, financial decisions become more and more complex as the amount
involves also is large.
b) Charitable
organization / Non-profit organization / Trust: In all those organizations,
finance is a crucial aspect to be managed. A finance manager has to concentrate
more on collection of donations/ revenues etc and has to ensure that every
rupee spent is justified and is towards achieving Goals of organization.
c) Government
/ Govt. or public sector undertaking: In central/ state Govt, finance is a key/
important portfolio generally given to most capable or competent person.
Preparation of budget, monitoring capital /revenue receipt and expenditure are
key functions to be performed by the person in charge of finance. Similarly, in
a Govt or public sector organization, financial controller or Chief finance
officer has to play a key role in performing/ taking all three financial
decisions i.e. raising of funds, investment of funds and distributing funds.
d) Other
organizations: In all other organizations or even in a family finance is a key
area to be looked in to seriously by a competent person so that things do not
go out of gear.
2)
Importance to all Stake holders
a) Share holders: Share holders are interested
in getting optimum dividend and maximizing their wealth which is basic
objective of financial management.
b) Investors / creditors: these stake holders
are interested in safety of their funds, timely repayment of the principal
amount as well as interest on the same. All these aspect are to be ensured by
the person managing funds/ finance.
c) Employees: They are interested in getting
timely payment of their salary/ wages, bonus, incentives and their retirement
benefits which are possible only if funds are managed properly and organization
is working in profit.
d) Customers: They are interested in quality
products at reasonable rates which is possible only through efficient
management of organization including management of funds.
e) Public: Public at large is interested in
general public welfare activities under corporate social responsibility and
this aspect is possible only when organization earns adequate profit.
f) Government: Govt is interested in timely
payment of taxes and other revenues from business world where again efficient
finance manager has a definite role to play.
g) Management: Management is interested in
overall image building, increase in the market share, optimizing share holders
wealth and profit and all these aspect greatly depends upon efficient
management of financial resources.
3)
Importance to other departments of an organization
A large size company, besides finance dept.,
has many departments like
a) Production
Dept
b) Marketing
Dept
c) Personnel
Dept
d) Material/
Inventory Dept
All these departments look for availability of
adequate funds so that they could manage their individual responsibilities in
an efficient manner. Lot of funds are required in production/manufacturing dept
for ongoing / completing the production process as well as maintaining adequate
stock to make available goods for the marketing dept for sale. Hence, finance
department through efficient management of funds has to ensure that adequate
funds are made available to all department and these departments at no stage
starve for want of funds. Hence, efficient financial management is of utmost
importance to all other department of the organization.
Objectives of Financial
Management
The firm’s investment and
financing decision are unavoidable and continuous. In order to make them
rational, the firm must have a goal. Two financial objectives predominate
amongst many objectives. These are:
1. Profit maximization
2. Shareholders’ Wealth
Maximization (SWM)
Profit maximization refers to
the rupee income while wealth maximization refers to the maximization of the
market value of the firm’s shares. Although profit maximization has been
traditionally considered as the main objective of the firm, it has faced
criticism. Wealth maximization is regarded as operationally and managerially
the better objective.
1. Profit maximization:
Profit maximization implies that either a firm produces maximum output for a
given input or uses minimum input for a given level of output. Profit
maximization causes the efficient allocation of resources in competitive market
condition and profit is considered as the most important measure of firm
performance. The underlying logic of profit maximization is efficiency.
In a market economy, prices
are driven by competitive forces and firms are expected to produce goods and
services desired by society as efficiently as possible. Demand for goods and
services leads price. Goods and services which are in great demand can command
higher prices. This leads to higher profits for the firm. This in turn attracts
other firms to produce such goods and services. Competition grows and
intensifies leading to a match in demand and supply. Thus, an equilibrium price
is reached. On the other hand, goods and services not in demand fetches low
price which forces producers to stop producing such goods and services and go
for goods and services in demand. This shows that the price system directs the
managerial effort towards more profitable goods and services. Competitive
forces direct price movement and guides the allocation of resources for various
productive activities.
2. Shareholders’ Wealth
Maximization: Shareholders’ wealth maximization means maximizing the net
present value of a course of action to shareholders. Net Present Value (NPV) of
a course of action is the difference between the present value of its benefits
and the present value of its costs. A financial action that has a positive NPV
creates wealth for shareholders and therefore, is desirable. A financial action
resulting in negative NPV destroys shareholders’ wealth and is, therefore
undesirable. Between mutually exclusive projects, the one with the highest NPV
should be adopted. NPVs of a firm’s projects are additive in nature. That is
NPV(A) + NPV(B) = NPV(A+B)
The objective of Shareholders
Wealth Maximization (SWM) considers timing and risk of expected benefits.
Benefits are measured in terms of cash flows. One should understand that in
investment and financing decisions, it is the flow of cash that is important,
not the accounting profits. SWM as an objective of financial management is
appropriate and operationally feasible criterion to choose among the
alternative financial actions.
5.
(a) “Capital
budgeting is long term planning for making and financing proposed capital
outlays.” Explain. What are the limitations of capital budgeting?
Ans: Meaning of Capital Budgeting or
Investment Decision
The term capital budgeting or investment
decision means planning for capital assets. Capital budgeting decision means
the decision as to whether or not to invest in long-term projects such as
setting up of a factory or installing a machinery or creating additional
capacities to manufacture a part which at present may be purchased from outside
and so on. It includes the financial analysis of the various proposals
regarding capital expenditure to evaluate their impact on the financial
condition of the company for the purpose to choose the best out of the various
alternatives.
According to Milton “Capital budgeting
involves planning of expenditure for assets and return from them which will be
realized in future time period”.
According to I.M Pandey “Capital budgeting
refers to the total process of generating, evaluating, selecting, and follow up
of capital expenditure alternative”
Capital budgeting decision is thus, evaluation
of expenditure decisions that involve current outlays but are likely to produce
benefits over a period of time longer than one year. The benefit that arises
from capital budgeting decision may be either in the form of increased revenues
or reduced costs. Such decision requires evaluation of the proposed project to
forecast likely or expected return from the project and determine whether return
from the project is adequate.
NEED AND IMPORTANCE OF CAPITAL
BUDGETING
Capital budgeting means planning for capital
assets. Capital budgeting decisions are vital to any organization as they
include the decisions as to:
a) Whether
or not funds should be invested in long term projects such as setting of an
industry, purchase of plant and machinery etc.
b) Analyze
the proposal for expansion or creating additional capacities.
c) To
decide the replacement of permanent assets such as building and equipments.
d) To
make financial analysis of various proposals regarding capital investments so
as to choose the best out of many alternative proposals.
The importance of capital budgeting can be
well understood from the fact that an unsound investment decision may prove to
be fatal to the very existence of the concern. The need, significance or
importance of capital budgeting arises mainly due to the following:
1)
Large
Investments: Capital budgeting decisions, generally, involve large
investment of funds. But the funds available with the firm are always limited
and the demand for funds far exceeds the resources. Hence it is very important
for a firm to plan and control its capital expenditure.
2)
Long-term
Commitment of Funds: Capital expenditure involves not only large amount of
funds but also funds for long-term or more or less on permanent basis. The
long-term commitment of funds increases the financial risk involved in the
investment decision. Grater the risk involved, greater is the need for careful
planning of capital expenditure, i.e. Capital budgeting.
3)
Irreversible
Nature: The capital expenditure decisions are on irreversible nature. Once
the decision for acquiring a permanent asset is taken, it becomes very
difficult to dispose of these assets without incurring heavy losses.
4)
Long-term
Effect on Profitability: Capital budgeting decisions have a long-term and
significant effect on the profitability of a concern. Not only the present
earnings of the firm are affected by the investments in capital assets but also
the future growth and profitability of the firm depends upon the investment
decision taken today. An unwise decision may prove disastrous and fatal to the
very existence of the concern. Capital budgeting is of utmost importance to
avoid over investment or under investment in fixed assets.
5)
Difficulties
of Investment Decisions: The long term investment decisions are difficult
to be taken because (i) decision extends to a series of years beyond the
current accounting period, (ii) uncertainties of future and (iii) higher degree
of risk.
6)
National
Importance: Investment decisions though taken by individual concern is of
national importance because it determines employment, economic activities and
economic growth.
This, we may say that without using capital
budgeting techniques a firm may involve itself in a losing project. Proper
timing of purchase, replacement, expansion and alternation of assets is
essential.
DISADVANTAGES OF CAPITAL
BUDGETING:
1. Capital budgeting decisions
are for long term and are majorly irreversible in nature.
2. Most of the times, these techniques are based
on the estimations and assumptions as the future would always remain uncertain.
3. Capital budgeting still remains introspective
as the risk factor and the discounting factor remains subjective to the
manager’s perception.
4. A wrong capital budgeting decision taken can
affect the long term durability of the company and hence it needs to be done
judiciously by professionals who understands the project well.
Or
(b) XYZ company has
currently an equity shares capital of Rs. 40 lakhs consisting of 40000 equity
shares of Rs. 100 each. The management is planning to raise another Rs. 30
lakhs to finance a major programme of expansion through one of the four
possible financing plans. The options are:
(i)
Entirely
through equity shares
(ii)
15 lakhs
in equity shares of Rs. 100 each and the balance in 8% debentures
(iii) Rs. 10 lakhs in equity shares of Rs. 100 each
and the balance through long-term borrowing at 9% interest p.a.
(iv) Rs. 15 lakhs in equity shares of 100 each and
the balance through preference shares with 5% dividend
The company’s expected earnings before
interest and taxes (EBIT) will be Rs. 50%, you are required to determine the
EPS and comment on the financial leverage that will be authorized under each of
the above scheme of financing.
SOLUTIONS:
LINK OF ALL PRACTICAL PROBLEMS VIDEOS
6.
(a) What do you mean by long term finance? Explain the importance of
debentures as a source of long term finance.
Or
(b) What is capital market? Why is it
consideration as a prerequisite for the economic development of a country like
India? Discuss.
7.
(a) What
is Modigliani Miller approach of irrelevance concept of dividends? Under what assumptions do the conclusions
hold good?
Ans: Modigliani and Miller approach (M & M
Hypothesis)
The residuals theory of
dividends tends to imply that the dividends are irrelevant and the value of the
firm is independent of its dividend policy. The irrelevance of dividend policy
for a valuation of the firm has been most comprehensively presented by Modigliani
and Miller. They have argued that the market price of a share is affected by
the earnings of the firm and not influenced by the pattern of income
distribution. What matters, on the other hand, is the investment decisions
which determine the earnings of the firm and thus affect the value of the firm.
They argue that subject to a number of assumptions, the way a firm splits its
earnings between dividends and retained earnings has no effect on the value of
the firm.
Like several financial theories, M&M
hypothesis is based on the argument of efficient capital markets. In addition,
there are two options:
(a) It retains earnings and finances its new
investment plans with such retained earnings;
(b) It distributes dividends, and finances its
new investment plans by issuing new shares.
The intuitive background of the M&M
approach is extremely simple, and in fact, almost self explanatory. It is based
on the following assumptions:
1) The capital markets are perfect and the
investors behave rationally.
2) All information is freely available to all the
investors.
3) There is no transaction cost.
4) Securities are divisible and can be split into
any fraction. No investor can affect the market price.
5) There are no taxes and no flotation cost.
6) The firm has a defined investment policy and
the future profits are known with certainty. The implication is that the
investment decisions are unaffected by the dividend decision and the operating
cash flows are same no matter which dividend policy is adopted.
Their conclusion is that, the shareholders get
the same benefit from dividend as from capital gain through retained earnings.
So, the division of earnings into dividend and retained earnings does not
influence shareholders' perceptions. So whether dividend is declared or not,
and whether high or low payout ratio is follows, it makes no difference on the
value of the share. In order to satisfy their model, MM has started with the
following valuation model.
P0= 1* (D1+P1)/
(1+ke)
Where,
P0 = Present
market price of the share
Ke = Cost of
equity share capital
D1 = Expected
dividend at the end of year 1
P1 = Expected
market price of the share at the end of year 1
With the help of
this valuation model we will create a arbitrage process, i.e., replacement of
amount paid as dividend by the issue of fresh capital. The arbitrage process
involves two simultaneous actions. With reference to dividend policy the two
actions are:
a) Payment of dividend by the firm
b) Rising of fresh capital.
With the help of
arbitrage process, MM have shown that the dividend payment will not have any
effect on the value of the firm. Even if the firm pays dividends, resulting in
a increase in market value of the share, the effect on the value of the firm
will be neutralised by the decrease in terminal value of the share.
Criticisms on MM Dividend theory: MM theory is criticized on
the invalidity of most of its assumptions. Some of the criticisms are presented
below:
1) First,
perfect capital market is not a reality.
2) Second,
transaction and floatation costs do exist.
3) Third,
Dividend has a signaling effect. Dividend decision signals financial standing
of the business, earnings position of the business, and so on. All these are
taken as uncertainty reducers and that these influence share value. So, the
stand of MM is not tenable.
4) Fourth,
MM assumed that additional shares are issued at the prevailing market price. It
is not so. Fresh issues - whether rights or otherwise, are made at prices below
the ruling market price.
5) Fifth,
taxation of dividend income is not the same as that of capital gain. Dividend
income upto Rs. 10000 is fully exempt, whereas capital gain attracts a flat 20%
tax in the case of individual assesses. So, investor preferences between
dividend and capital gain differ.
6) Sixth,
investment decisions are not always rational. Some, sub-marginal projects may
be taken up by firms if internally generated funds are available in plenty.
This would deflate ROI sooner than later reducing share price.
7) Seventh,
investment decisions are tied up with financing decisions. Availability of
funds and external constrains might affect investment decisions and rationing
of capital, then becomes a relevant issue as it affects the availability of
funds.
Or
(b)What do you understand
by retained earning? How and in what ways ploughing back of profits can short
out the financial problems of a business unit?
Ans: Retained Earnings or Ploughing Back of
Profit
Retained earnings are an internal sources of
finance for any company. Actually is not a method of raising finance, but it is
called as accumulation of profits by a company for its expansion and
diversification activities. Retained earnings are called under different names
such as self finance, inter finance, and plugging back of profits. As prescribed by the central government, a
part (not exceeding 10%) of the net profits after tax of a financial year have
to be compulsorily transferred to reserve by a company before declaring dividends
for the year.
Under the retained earnings sources of
finance, a reasonable part of the total profits is transferred to various
reserves such as general reserve, replacement fund, reserve for repairs and renewals,
reserve funds and secrete reserves, etc.
Retained earnings or profits are ploughed
back for the following purposes.
a) Purchasing
new assets required for betterment, development and expansion of the company.
b) Replacing
the old assets which have become obsolete.
c) Meeting
the working capital needs of the company.
d) Repayment
of the old debts of the company.
Retained earnings can sort out the financial
problems of a concern in the following ways:
1. Useful for expansion and diversification:
Retained earnings are most useful to
expansion and diversification of the business activities.
2. Economical sources of finance: Retained
earnings are one of the least costly sources
of finance since it does not involve any floatation cost as in the case of raising of funds by issuing different
types of securities.
3. No fixed obligation: If the companies use
equity finance they have to pay dividend and if the companies use debt finance,
they have to pay interest. But if
the company uses retained earnings as sources of finance, they need not pay any fixed obligation regarding the
payment of dividend or interest.
4. Flexible sources: Retained earnings allow
the financial structure to remain completely
flexible. The company need not raise loans for further requirements, if it has retained earnings.
5. Increase the share value: When the company
uses the retained earnings as the sources
of finance for their financial requirements, the cost of capital is very
cheaper than the other sources of
finance; Hence the value of the share will increase.
6. Avoid excessive tax: Retained earnings
provide opportunities for evasion of excessive
tax in a company when it has small number of shareholders.
7. Increase earning capacity: Retained
earnings consist of least cost of capital and also it is most suitable to those companies which go for
diversification and expansion.
8.
(a) What is inventory
management? Discuss its objectives. How is ABC analysis useful as a tool of
inventory management?
Or
(b) From the information given below you are required to
prepare a statement of working capital requirements:
(i)
Issued shares capital 200000
8% Bonds 75000
Fixed assets at cost 200000
(ii) The
expected ratio of cost to selling price are:
Raw
materials 40%
Labour 30%
Overheads 20%
Profit 10%
(iii) Raw
materials are kept in store for an average of two months
(iv) Finished
goods remain in store for an average period of one months
(v) Work in
process (100% complete in regard to materials and 50% for labour and overheads)
will approximately be to half a month’s production
(vi) Credit allowed
to customers is two months and given by suppliers is one month
(vii) Production
during the previous year was 40000 units and it is planned to maintain the same
in current year also
(viii)
Selling price is Rs. 9 per units
(ix) Calculation
of debtors may be made at selling price
SOLUTIONS:
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